VALUE : investment criteria
The criteria on which investment decisions are based include:
- first and foremost, net present value (NPV), which is the best criterion because it measures the value creation of the investment;
- the internal rate of return (IRR), which measures the yield to maturity of the investment; and
- if necessary and to simplify calculations, the payback ratio, which measures the amount of time needed to pay back the investment, and the return on capital employed (operating profit after tax for the period divided by capital employed for the period), which is more of a financial control tool.
The flows that are used for calculating NPV and IRR are free cash flows:
- EBITDA on the investment;
- corporate income tax calculated on the operating income of the investment;
- change in working capital created by the investment;
- capital expenditure (including any divestments).
To avoid making errors, it is necessary to:
- reason only in terms of cash flow, not charges and revenues;
- reason in terms of incremental flows – i.e. consider the cash flows arising on the investment, all the cash flows arising on the investment and only the cash flows arising on the investment. This involves calculating the investment's marginal contribution to the company's cash flows;
- reason in terms of opportunity – i.e. in financial values and not in book values;
- disregard the way in which the investment was financed – flows used in the calculations never include financial income and expenditure, new loans and repayment of loans, capital increases and capital reductions or dividends;
- consider ordinary taxation (on operating profits) or exceptional taxes (on capital gains, subsidies, etc.); and
- finally, the best advice is to be consistent!
In the business world, the differences between practice and theory in investment decisions are diminishing. Financial managers now look increasingly at NPV and IRR when making investment decisions.